As I wrote this in the second week of February, share prices throughout the world were falling. I do not know what will be happening when you read this. I don’t forecast share prices. This sets out how to think about such events.

Ian Cross says that I was one of two New Zealanders who forecast the collapse of share prices in 1987. (The other was Rob Muldoon.) If so, it was a byproduct of explaining how the share market was working. Towards the end of this column I’ll explain why the method I used then is not so relevant today. It is always different this time but the general analysis remains much the same.

Charles/Carlo Ponzi was not he first to devise a Ponzi scheme (Dickens describes two in his novels) but his swindle of the 1920s is a useful beginning to discuss financial dealings; shares work differently in some ways though.

Ponzi promised exceptionally high returns, doubling one's money in three months. (He justified them by claiming he could arbitrage international reply coupons; you don’t need to know.) Funds trickled in; at the end of the three months he paid the promised return. Many reinvested their funds, but those who took their profits were paid out from the funds that later investors had deposited. Learning that the scheme was paying as promised attracted more funds, which were used to pay the next lot of investors and so on.

Of course the cycle could not go on forever. After a while, there were insufficient new funds coming in to pay the outgoings. Payouts stopped, investor confidence collapsed, and those with deposits still in the scheme lost their funds. (The international reply coupons generated very little.)

Let’s simplify. Suppose that investors had $10m of funds and they put $1m on day one (say March 1) into Ponzi’s scheme, another $1m a month later (April 1), another $1m on May 1 and on June 1.

By early June Ponzi has received $4m. Out of this, he pays $2m to the March investors. Aggregating up, the investors have $8m in cash and think they have $3m (from the April, May and June deposits) with Ponzi. But he has only $2m in cash to offset the $3m the scheme owes (together with more for the return on the investment).

You can complicate this story but if investors put in only $1m every month, by August Ponzi would have paid out all his deposited cash, has nothing left and he still owes at least $3m to his depositors. (In practice the boom lasts longer because the promise of the scheme attracts even more funds.)

So it is necessary to keep an eye on both the investors’ cash position and their have financial contracts (deposits) which may or may not be worthless (not backed by equally valuable assets) irrespective of what the contracts promise.

When they are functioning properly, shares are not Ponzi schemes. There is, of course, the cash and there are the financial contracts (this time, shares) which may, or may not be worth what they are said to be. The difference is that, unlike arbitraging coupons, there is some return to the shares arising from the dividends which the businesses pay to shareholders.

However, sometimes irrational exuberance takes over, investors become besotted by capital gains and dividends become almost irrelevant in their decisions. When the price of a share goes up, they may feel wealthier but their cash holdings do not increase. Dividends and expenses aside, there is no change in total investor cash holdings. You really get the wealth only if you sell the share to someone else. At this point the sharemarket becomes much like a Ponzi scheme in that you can only make a money profit from it by exchanging your share for someone else’s cash.

When the share market is bubbling along it is relatively easy to convince yourself things are going well, even if the bubble is irrational. But if the sentiment becomes depressed, you find you can sell your shares only at a discount, so investors feel worse off even though they are holding the same amount of cash.

Does then, a share price fall matter other than to the way investors feel about themselves? They may cut back on their spending. There might be, say, fewer BMWs sold which is tough on BMW dealers. So there may be an economic contraction. Usually this is not a big effect.

Once upon a time we would have put considerable stress on the role of the share market in raising capital. That would mean a share price fall would make it harder to fund business investment. Recent research concludes that today more important sources of funding are retained business earnings and bank (and the like) loans. Perhaps a share falls’ bigger impact on business investment is if businesses become more pessimistic about their prospects.

There is one further complication from a share price fall. Suppose some of the investors have financed their share purchases by borrowing. If the share price goes up, their apparent wealth goes up (it actually does if they sell their shares) while the debts are fixed so they make a bigger capital gain. (This is called ‘leveraging’.) If the price falls, it may go below their debts and they are in trouble.

This can always happens but when the leveraging is widespread a share price fall impacts heavily on the financial system (and the economy). That is what happened in 1929 and to some extent in 1987 and 2008.

There was another even more fundamental problem in 1987. Many of the local firms were reporting corrupted estimates of their underlying profitability. What was going on was closer to a Ponzi scheme than market commentators were willing to admit.

When I analysed share prices in 1987 I focused on the (share) ‘price to earnings’ (profitability) ratio, pointing out that the level at the time was way out of line with historic trends. That meant either there would have to be a big rise in profitability (there wasn’t) or there would have to be a ‘correction’ – a big one – (there was). I could do the same analysis today but the equilibrium trend has to be adjusted for the far lower interest rates we are experiencing. (I have yet to see a decent analysis.)

I do not think there is the same corruption today, but there has been, in my opinion, excessive irrational exuberance. (When commentators use the euphemism ‘correction’ they are implicitly admitting it.) The return to realism may result in share price falls but not affect the economy too much. It there is a panic from a big fall, the three channels already mentioned – reduced investor expenditure, reduced business investment and financial defaults arising from excessive leverage – may all cut in.

Those involved are likely to say the share market is terribly important. Journalists like it too, because it gives instant news and comment (even though it may be meaningless). For an economist it is just another market with its generalities and particularities. A large market going wrong impacts on the economy as a whole.

Any investing in financial contracts is a gamble, since it involve future promises to pay and you cannot be sure that they will be fulfilled. Sometimes the gamble – say a deposit in a bank – is not very risky (and the return is not high). Sometimes – say in a Ponzi scheme or a bitcoin bubble – the risks are much higher although the average return may, in retrospect, be not that much better, Writing about the share market, the German poet Hans Magnus Enzenberger said ‘the reader of the Financial Times shouldn’t be deprived of what the reader of [the tabloid] Der Bild gets. Everybody has a right to a daily horoscope.’

PS. This column does not address when shares in a particular business are in turmoil while the market is stable. (Fletcher Building is a current example.)

Which would seem to indicate that any market investment would tend to return only the long term bond rate - holding a "high-growth" portfolio, for instance would eventually result in the gains due to growth being wiped out through crashes and company failures (clearly, some investors will get lucky and consider themselves geniuses, others will lose bigger, not match the risk-free return and keep quiet about it).

Which in turn suggests that any retirement fund will (since long term bond rates == inflationary expectations) will only match inflation and thus have a zero real return - in real terms, the retirees will only recieve the funds they saved.

I'm an investor and I invest mostly for the dividend. I don't buy and sell shares, I just buy and hold over many years. So short term price fluctuations mean little to me - I haven't even checked out the value of my portfolio in months.

If there is a sudden drop in the NZ market caused by someone in another country getting cold feet for seemingly no rational reason (as happened recently) then it's just a buying opportunity for me.

In my view a trader is essentially a gambler unless he's an inside trader, and someone once told me that's cheating.

You're right about the media - they make a big fuss about a drop in the market because if it bleeds, it leads. But for most investors, it's irrelevant.

The biggest problem I see in today's share markets is the great separation between the owner and the business.

The average 'owner' (i.e. shareholder) today knows basically nothing about the business they are invested in. They might have bought an indexed linked fund or have a portfolio or pension fund manager run their investments for them. They may have a term deposit in a bank which is subsequently invested in the market. Most have never read a balance sheet of their shares and may not even be able to access information on what they own at any particular point in time.

This has transferred the power of ownership into the hands of the grey men who inhabit the world between the owner and the asset.

These are the people making the real money in today's world and they're using someone else's savings to do it. Not surprisingly, this is also where most of the malfeasance occurs. Deals done at the country club that retail investors such as myself never get a sniff of. Efficient Market Hypothesis - yeah right!

At the same time, these people have bought politicians (not here but certainly in the US) so don't expect anything to be done about this any time soon. Only Bernie Madoff went to jail after the GFC.